Final Tangible Property
Regulations:
Overview
Richard G. Furlong, Jr.
Main Line Association for Continuing Education
Penn State Great Valley Conference Center
October 22, 2015
Internal Revenue Code - General Rules

Section 162 allows a deduction for ordinary and
necessary business expenses, including amounts paid
for incidental repairs and maintenance.

Section 263(a) requires taxpayers to capitalize, rather
than deduct, amounts paid to acquire, produce, or
improve tangible and intangible property.

Capitalized costs generally are recovered through
depreciation (for tangible property) or amortization (for
intangible property).
2
Purpose of Final Regulations

The final regulations combine the case law and other
authorities into a useful framework to assist taxpayers in
distinguishing currently deductible tangible property
costs from capital expenditures.

In addition, the final regulations simplify the deduction
and capitalization rules for tangible property through-
Safe harbors

Conventions

Elections
3
Overview of Final Tangible Property
Regulations under Sections 162 & 263(a)

§ 1.162-3 – Material and Supplies

§ 1.162-4 – Repairs and Maintenance

§ 1.263(a)-1 – Capital Expenditures; in general

§ 1.263(a)-1(f) – De Minimis Safe Harbor Election

§ 1.263(a)-2 – Acquisition and Production of Tangible
Property

§ 1.263(a)-3 – Improvements to Tangible Property
4
Acquisition and Production Costs –
§ 1.263(a)-2

Requirement to Capitalize – A taxpayer must
capitalize amounts paid to acquire or produce a
unit of real or personal property (UOP), including-




Invoice price;
Transaction costs;
Costs for work performed prior to the date the UOP is
placed in service by the taxpayer; and
Amounts paid to defend or perfect title to a UOP
Important Exceptions:


De Minimis Safe Harbor Election -- § 1.263(a)-1(f)
Materials and Supplies -- § 1.162-3
5
De Minimis Safe Harbor Election Purpose


The de minimis safe harbor election is intended
to eliminate the burden of determining whether
every small-dollar expenditure for the
acquisition or production of property is properly
deductible or capitalizable.
If a taxpayer elects to use the de minimis safe
harbor, the taxpayer does not have to capitalize
the cost of certain de minimis acquisitions.
6
De Minimis Safe Harbor Election Effect


A safe harbor; Not a limitation!
An otherwise deductible amount is still deductible, even
if the amount does not qualify under the de minimis safe
harbor:




Incidental materials and supplies,
Non-incidental materials and supplies, or
Repair and maintenance costs.
The de minimis safe harbor election does not impose
any additional capitalization requirements beyond the
requirements that were already in place prior to the final
regulations.
7
Applicable Financial Statement (AFS)



A financial statement required to be filed with the Securities and
Exchange Commission (SEC) (the 10-K or the Annual Statement to
Shareholders);
A certified audited financial statement that is accompanied by the
report of an independent certified public accountant (or in the case
of a foreign entity, by the report of a similarly qualified independent
professional) that is used for—

Credit purposes;

Reporting to shareholders, partners, or similar persons; or

Any other substantial non-tax purpose; or
A financial statement (other than a tax return) required to be
provided to the federal or a state government or any federal or
state agency (other than the SEC or the Internal Revenue Service).
8
De Minimis Safe Harbor
Taxpayers with Applicable Financial Statements

A taxpayer electing the de minimis safe harbor may deduct and not
capitalize or treat as materials or supplies amounts paid to acquire or
produce a unit of tangible property, and if—

The taxpayer has an AFS;

The taxpayer has, at the beginning of the taxable year, written
accounting procedures treating as an expense for non-tax
purposes—
o
Amounts paid for property costing less than a certain dollar
amount; or
o
Amounts paid for property with an economic useful life of 12
months or less;

The taxpayer treats the amounts paid during the taxable year as
an expense on its AFS in accordance with its written accounting
procedures; and

The amount paid for the property does not exceed $5,000 per invoice
(or per item substantiated by invoice).
9
De Minimis Safe Harbor
Taxpayer without Applicable Financial Statement

A taxpayer electing the de minimis safe harbor may deduct and not
capitalize or treat as materials or supplies amounts paid to acquire or
produce a unit of tangible property, and if—

The taxpayer does not have an AFS;

The taxpayer has, at the beginning of the taxable year, accounting
procedures treating as an expense for non-tax purposes—
o
Amounts paid for property costing less than a certain dollar
amount; or
o
Amounts paid for property with an economic useful life of 12
months or less;

The taxpayer treats the amounts paid for the property as an
expense on its books and records in accordance with its accounting
procedures; and

The amount paid for the property does not exceed $500 per invoice
(or per item substantiated by invoice).
10
De Minimis Safe Harbor – Election and Coordination
with Section 263A

The De Minimis Safe Harbor is an annual election. It is
not a change of accounting method. How to Make the
Election will be discussed later.

Even if the taxpayer elects the de minimis safe harbor,
amounts paid for tangible property qualifying under the
safe harbor may be subject to capitalization under
section 263A if the amounts paid for property comprise
the direct or allocable indirect costs of other property
produced by the taxpayer or property acquired for
resale.
11
Effect of Final Tangible Property Regulations
on Materials and Supplies Rules

In most cases, the final regulations do not change the
general rules for deducting materials and supplies.

Merely incorporate pre-existing precedents regarding
the definition and treatment of materials and supplies

Add safe harbors to provide additional certainty for
taxpayers.
12
Materials & Supplies – § 1.162-3

Definition: A material or supply is tangible property that is used or
consumed in the taxpayer’s operations, that is not inventory, and that—

Components - Is a component acquired to maintain, repair, or
improve a unit of property (UOP) owned, leased, or serviced by the
taxpayer and that is not acquired as part of any single unit of tangible
property; or

Consumables - Consists of fuel, lubricants, water, and similar items
that are reasonably expected to be consumed in 12 months or less,
beginning when used in operations; or

12 Month Property - Is a UOP that has an economic useful life of 12
months or less, beginning when the property is used or consumed in
the taxpayer’s operations; or

$200 Property - Is a UOP that has an acquisition cost or production
cost of $200 or less; or

Other Identified Property - Is identified in published guidance.
13
Materials and Supplies – Treatment

Incidental Materials & Supplies – Amounts paid to
acquire or produce incidental materials and supplies
that are carried on hand and for which no record of
consumption is kept or of which physical inventories at
the beginning and end of the year are not taken, are
deductible in the taxable year in which these
amounts are paid or incurred, provided taxable
income is clearly reflected

Non-Incidental Materials & Supplies – Deductible in
year in which the materials and supplies are first used
in the taxpayer’s operations or are consumed in the
taxpayer’s operations.
14
Materials and Supplies – Treatment
Continued

Rotable & Temporary Spare Parts – Three Options:




Deductible in the taxable year in which the taxpayer
disposes of the part;
Elect to Capitalize and Depreciate (also Standby
Emergency Spare Parts); or
Optional Method of Accounting for Rotable and
Temporary Spare Parts;
De minimis Safe Harbor – Taxpayer must apply the de
minimis safe harbor, if elected, to materials and
supplies that qualify under the safe harbor.
15
Applying the Final Regulations to Materials
and Supplies

Because the final regulations governing the treatment of
materials and supplies are based primarily on prior law,
many taxpayers who were previously in compliance
with the rules generally will still be in compliance.

Generally no action will be required to continue to apply
these rules on a prospective basis.

Taxpayers who are not in compliance or who want to
change one or more accounting methods to begin using
certain beneficial aspects of the materials and supplies
rules generally would change their method of
accounting. How the change is made will be discussed
16
later.
Effect of Final Regulations on Improvements v.
Repairs – Simplifying Alternatives

If the amounts are not for an improvement to tangible
property, then the amounts are generally deductible as
repairs and maintenance expenses.

Tax law has always required an evaluation of the taxpayer’s
facts and circumstances (facts and circumstances analysis).

The final regulations provide several safe harbors and
simplifying elections to ease taxpayers’ compliance with
these rules:
• Safe Harbor Election for Small Taxpayers
• Safe Harbor for Routine Maintenance
• Election of Capitalize Repair and Maintenance Costs
17
Improvements to
Units of Property (UOP)

Improvements to tangible property must be capitalized under
IRC 263(a)

Was an improvement made? Ask yourself the following
questions:
1.
What is the unit of property to be analyzed for determining
whether there is an improvement?
2.
Does the work performed constitute an improvement to
the relevant unit of property?
18
Question 1. Unit of Property – § 1.263(a)3(e) Analytical Framework

Categories of Property–

Buildings (including Condos, Coops, and Leased Buildings
or Leased Parts of Buildings)

Non-Buildings (all components that are functionally
interdependent)

o
Plant Property (e.g., manufacturing plant)
o
Network Assets (e.g., railroad track)
o
Leased Property other than Buildings
Additional Rule – Different MACRS class or
method
19
Unit of Property – Buildings
§ 1.263(a)-3(e)(2)

The unit of property is the building and its structural components.

However, an amount is paid to improve a building if the amount is
paid for an improvement to—

Building Structure (building and structural components except
for designated building systems); or

Any Building System-o HVAC
o Plumbing
o Electrical
o Escalators
o Elevators
o
o
o
o
Fire Protection and Alarm
Security
Gas Distribution
Systems identified in guidance
20
Unit of Property –Non-Buildings
§ 1.263(a)-3(e)(3)
General Rule - Functional Interdependence

All components that are functionally interdependent
comprise a single unit of property.

Components are functionally interdependent if the
placing in service of one component is dependent
on the placing in service of the other component.
21
Non-Buildings
Exception to Functional Interdependence

Plant Property - § 1.263(a)-3(e)(3)(ii)

Definition: Machinery or equipment used to perform
an industrial process, such as manufacturing,
generation, warehousing, distribution, automated
materials handling in service industries, or other
similar activities.

Rule: The unit of property is comprised of each
component (or group of components) within the plant
that performs a discrete and major function or
operation within the functionally interdependent
machinery or equipment.
22
Unit of Property—Depreciation Conformity
Exception – § 1.263(a)-3(e)(5)

Depreciation Conformity – Separate Unit of Property
If at the time the UOP is initially placed in service and the taxpayer has
properly treated the component as being within a different MACRS class
than the class of the UOP of which the component is a part or, the
component was properly depreciated using a different depreciation method
than the depreciation method of the Unit of Property of which the component
is a part, then it must be treated as a separate unit of property.

Subsequent Change in Classification– Consistent Change in Treatment
In any taxable year after the UOP is initially placed in service by the
taxpayer, if taxpayer or IRS changes the treatment of that property to a
proper MACRS class or a proper depreciation method (for example, as a
result of a cost segregation study or a change in the use of the property),
then the taxpayer must change the UOP determination for that property
under this section to be consistent with the change in treatment for
depreciation purposes.
23
Question 2. Determining an Improvement to
the Unit of Property

General Rule - § 1.263(a)-3(d)

An improvement is defined as amounts that:

Are for a betterment to the unit of property;

Restore the unit of property; or

Adapt the unit of property to a new or different
use.
24
Betterments - § 1.263(a)-3(j)

An UOP is improved as a betterment only if the amount
paid—




Fixes a material condition or material defect that existed
prior to the acquisition or that arose during the production of the
property; or
Is for a material addition (including a physical enlargement,
expansion, extension, or addition of a major component) to the
UOP or a material increase in capacity (including additional
cubic or linear space) of the UOP; or
Is reasonably expected to materially increase the
productivity, efficiency, strength, quality, or output of the
UOP.
Appropriate Comparison - Normal wear and tear or
damage during the use of the property
25
Restorations - § 1.263(a)-3(k)
An amount restores a unit of property (or in the case of a
building, the building structure or a building system) only if it
meets one of the following 6 criteria—
1.
The amounts paid is for the replacement of a component of
the UOP and the taxpayer has properly deducted a loss
for that component (other than a casualty loss); or
2.
The amounts paid for the replacement or a component of
the UOP and the taxpayer has properly taken into account
the adjusted basis of the component in realizing gain or
loss resulting from the sale or exchange of the
component; or
26
Restorations - § 1.263(a)-3(k) - Continued
3.
The amounts paid is for the restoration of damage to the
property for which the taxpayer is required to take a basis
adjustment as a result of a casualty loss under section
165, or relating to a casualty event described in section 165,
but limited to the basis in the UOP; or
4.
The amounts paid returns the property to its ordinarily efficient
operating condition if the UOP has deteriorated to a state of
disrepair and is no longer functional for its intended use; or
5.
The amounts paid results in the rebuilding of the UOP to a
like-new condition after the end of its class life; or
6.
The amounts paid is for the replacement of a part or
combination of parts that comprise a major component or a
substantial structural part of the UOP.
27
Replacement of a Major Component or Substantial
Structural Part - § 1.263(a)-3(k)(6)
 Major
Component - performs a discrete and critical
function, except “incidental components”

Special Rule for Buildings – a major component can also
include a significant portion of a major component of the
building structure or a building system
o Example: Taxpayer replaces 60% of the pipes in its
plumbing system - Pipes would be a major component,
and 60% would be a significant portion of that major
component.
 Substantial
Structural Part - a part or combination of parts
that make up a large portion of the physical structure of the
unit of property (or in the case of a building, the building
structure or a building system)
28
Amounts that Adapt Property to a
New or Different Use - § 1.263(a)-3(l)

An amount is paid to adapt a UOP (or in the case
of a building, the building structure or a building
system) to a new or different use if the adaptation
is not consistent with the taxpayer’s ordinary
use of the property at the time originally placed
in service by the taxpayer

Example:
Amounts paid to convert a manufacturing plant
into a retail showroom adapts the building
structure to a new or different use.
29
Safe Harbor for Small Taxpayers
§ 1.263(a)-3(h) – General Rule
The requirements of the safe harbor election for small taxpayers are:

Average annual gross receipts less than $10 million; and

Owns or leases building property with an unadjusted basis of less
than $1 million; and

The total amount paid during the taxable year for repairs,
maintenance, improvements, or similar activities performed on
such building property doesn't exceed the lesser of:
 2% of the unadjusted basis of the eligible building property; or
 $10,000

If amounts paid by the taxpayer during the taxable year for an
eligible building exceed this limitation, then the taxpayer must apply
the general rules of the final regulation to all its amounts paid in
connection with that building to determine the proper treatment.
30
Safe Harbor for Routine Maintenance
§ 1.263(a)-3(i) – General Rule
General Rule: An amount paid for routine maintenance on a Unit of
Property does not improve the property.
What is Routine Maintenance?
Amounts that meet all of the following criteria:

Amounts paid for recurring activities that it expects to perform; and

As a result of use of the property in its trade or business; and

To keep the property in its ordinarily efficient operating condition; and

The taxpayer reasonably expects, at the time the property is placed in
service, to perform the activities:

For building structures and building systems, more than once
during the 10-year period beginning when placed in service, or

For property other than buildings, more than once during the
class life of the unit of property.
31
Safe Harbor for Routine Maintenance
Application Rules

Exception and Inclusion:

Betterments - doesn't apply

Restorations – does apply in certain cases
 If
all of the requirements for the routine maintenance safe
harbor are not met, the amounts may be deductible under the
facts and circumstances analysis.
 Generally,
no action is required for taxpayers who were in
compliance with prior rules.
 Taxpayers
that are not in compliance or that want to use the
safe harbor method generally would change their method of
accounting. How to make the election will be discussed later.
32
Election to Capitalize Repair and
Maintenance Costs - § 1.263(a)-3(n)
General Rule - A taxpayer may elect to treat repair
and maintenance costs paid during the taxable year
as improvements subject to the allowance for
depreciation if:

The taxpayer pays these amounts in carrying
on a trade or business; and

The taxpayer treats these amounts as capital
expenditures on its books and records
regularly used in computing its income.
33
Applicability Dates

Generally, the final regulations apply to taxable
years beginning on or after January 1, 2014.

In certain circumstances (such as the de
minimis safe harbor & the materials and
supplies rules) the final regulations apply to
amounts paid or incurred in taxable years
beginning on or after January 1, 2014.
34
Making an Election
An election is made annually and it is not a change of accounting
method. You do not file a Form 3115, Application for Change in
Method of Accounting, to make an election or to stop applying an
election for a subsequent tax year.

You make an election by attaching a statement for each election to
your timely filed original federal tax return including any extensions
for the taxable year in which the amounts subject to the election
are paid.
For each of the Elective Provisions the statement should be titled as
follows:

“Section 1.263(a)-1(f) De Minimis Safe Harbor Election”

“Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers”

“Section 1.263(a)-3(n) Election” for the Election to Capitalize
Repair and Maintenance Costs
35

Making an Election – Continued
The statement should include the following:
 The taxpayer’s name
 Address
 Tax Identification Number, and
 A statement indicating that the taxpayer is making
(specify the election)
 For the Safe Harbor Election for Small Taxpayers the
statement requires you to include a description of each
eligible building property to which you are applying the
election
36
Method Changes to Comply with the
Final Regulations

In general, many taxpayers will be required to change
their methods of accounting to utilize certain provisions
in the final regulations.

A change in method of accounting includes a change in
the treatment of an item affecting the timing for
including the item in income or the timing for taking the
item as a deduction.

For example, a taxpayer that has been capitalizing certain
amounts that it characterized as improvements and that would
like to currently deduct the amounts as repairs and
maintenance costs pursuant to the final regulations is changing
its method of accounting.
37
Method Changes to Comply with the
Final Regulations - Continued

To change a current accounting method to a new
accounting method, a taxpayer is required to obtain the
Commissioner’s consent.

The Treasury Department and the IRS have provided
automatic consent procedures for taxpayers that want
to change to a method of accounting permitted under
the final regulations. The detailed rules are provided in
Rev. Proc. 2015-13 and Rev. Proc. 2015-14 (Sections
6.37-6.40 and 10.11).
38
Method Changes to Comply with the
Final Regulations – Form 3115

Generally, a taxpayer makes an automatic change to an
accounting method by completing and filing a Form 3115,
Application for Change in Accounting Method, and including
it with the taxpayer’s timely filed original federal tax return for
the year of change.

The taxpayer must also file a duplicate copy of its completed
Form 3115 with the IRS at Internal Revenue Service 1973
Rulon White Blvd. Mail Stop 4917 Ogden, UT 84201-1000

This application identifies the taxpayer, describes the
methods that are being changed, identifies the type of
property involved, and includes a section 481(a) adjustment,
if applicable.
39
Simplified Procedures for Small Business
Taxpayers – Rev. Proc. 2015-20

To ease the administrative burden faced by small business taxpayers that
want to prospectively apply the final regulations, and do not wish to
compute a section 481(a) adjustment, the IRS has provided a simplified
procedure that these taxpayers may use for their first taxable year
beginning in 2014.

Under this procedure, a taxpayer with a qualifying small business may
choose to change to certain methods of accounting under the final
regulations by taking into account only amounts paid or incurred in taxable
years beginning on or after January 1, 2014.

If a taxpayer chooses this procedure for its small business, then the small
business will not have a section 481(a) adjustment for its first taxable year
beginning 2014, and will not be required to file a Form 3115 to start using
the final regulations for 2014.
40
Simplified Procedures for Small Business
Taxpayers – Who Qualifies?

A taxpayer may choose to apply this procedure to each separate
trade and distinct trade or business that meets one or both of
the following criteria:

Total assets of less than $10 million; or

Average annual gross receipts of $10 million or less for the
prior three taxable years.

If a taxpayer has more than one separate and distinct trade or
business, the taxpayer can only choose the simplified procedure for
the trades or business that meet at least one of the criteria
specified above.
A taxpayer may not choose the simplified procedure for any trade
or business that does not meet at least one of the criteria above.

41
Simplified Procedures for Small Business
Taxpayers – Definitions



Separate and Distinct Trade or Business refers to
each trade or business for which the taxpayer keeps a
complete and separate set of books and records
Total Assets are determined by the accounting method
regularly used by the taxpayer in keeping the books and
records of the trade or business at the end of the tax
year
Gross receipts are the trade or business’s receipts for
the taxable year that are properly recognized under its
method of accounting used for federal tax purposes.
For more information, see § 1.263(a)-3(h)(3)(iv) of the
regulations.
42
Simplified Procedures for
Small Business Taxpayers – Effect of Election

If a taxpayer chooses this procedure for a qualifying trade or
business-


For that business, the taxpayer may not take into account
certain dispositions of tangible property occurring in taxable
years beginning before January 1, 2014, or may not make a
late partial disposition election for a disposition during that
period; and
The taxpayer does not receive audit protection for that trade or
business for amounts paid or incurred in taxable years
beginning before January 1, 2014, and subject to this
procedure.
The trade or business must utilize this procedure for all
changes specified under the procedure, and may not pick and
choose which final regulation methods apply prospectively.
43
Simplified Procedures for Small Taxpayers
Other Considerations

Generally, if a taxpayer has a separate trade or business that
qualifies under these procedures, and does not file a Form 3115 and
include a Section 481(a) adjustment for its first taxable year
beginning Jan. 1, 2014, then the taxpayer will be presumed to have
changed its method for amounts incurred under the final regulations
under these procedures.

Thus, if this taxpayer decides to change these accounting methods
for the same business in later taxable year by filing a Form 3115 and
calculating a section 481(a) adjustment in the later year, then the
section 481(a) adjustment is calculated by taking into account only
amounts paid or incurred, and dispositions, in taxable years
beginning in 2014.
44
Summary

Generally, Materials, Supplies, and Repairs and
Maintenance are deductible expenses.

An amount paid for the betterment, restoration, or
adaptation to unit of tangible property must be capitalized.

Elections (e.g., De Minimis) – No Form 3115 is needed.
An annual election is NOT a change in method of
accounting.

Form 3115 is needed for method changes to comply with
the Final Regulations. Qualifying Small Business
Taxpayers may use the Simplified Procedures in Rev Proc
2015-20
45
IRS.gov Resources





Final Tangible Regulations [Treasury Decision
9636]
IRS.gov/Businesses/Small-Businesses-&-SelfEmployed/Tangible-Property-Final-Regulations
(FAQs)
Revenue Procedure 2015-20 for qualifying
small business taxpayers
Rev. Proc. 2015-13
Rev. Proc. 2015-14 (section 10.11)
46
Contact Information
Richard G. Furlong, Jr.
Senior Stakeholder Liaison
IRS Small Business/Self-Employed
Division
267-941-6343
richard.g.furlong@irs.gov
47